There are all kinds of sub-strategies floating around about how to use a Roth IRA as something other than a retirement account. Most involve using it as some form of a short- or medium-term savings strategy. This can include using it as an emergency fund, a backdoor college fund for your kids, or even a nest egg for the down payment on a new home.
Those strategies revolve around the fact that Roth IRAs have an unusual provision among tax-deferred retirement plans. This being, of course, the fact you can withdraw the amount of your contributions (and conversion amounts) from the plan without incurring either ordinary income tax or the 10% early withdrawal penalty.
But just because you can access the money in a Roth IRA tax-free and penalty-free doesn't mean that you should. So, let's explore the reasons why your Roth IRA should be used for retirement, and not for any other purpose.
A Roth IRA is First and Foremost a Retirement Plan
The Roth IRA was set up to be a retirement plan. The short-term and medium-term savings strategies were unintended consequences, based on the ability to withdraw contributions from the plan early without having to pay taxes or penalties.
Resource: Roth IRA Contribution Limits for 2021
In a way, that provision can be the undoing of your Roth IRA plan. Most people tend to accumulate the majority of their savings through retirement plans. Because of this, using padded Roth funds for short-term purposes can be very enticing.
If you have long-term plans to rely on your Roth IRA as a significant part of your retirement strategy, then you will have to allow the account to grow large enough that it will be able to provide you with a credible income stream. If you raid the account every year (or every few years) for some short-term purpose, your account will never serve as the retirement plan was intended to be.
This actually brings us back to why a Roth IRA is a necessary part of a larger retirement strategy...
With no RMD requirement, a Roth should be the longest of long-term investments
Not only should a Roth IRA not be used for short-term purposes, but it is actually the best-suited retirement plan for very long-term investing. That’s because another important feature of the Roth IRA is that it’s the only tax-sheltered retirement plan that will not be subject to required minimum distributions, or RMDs.
This isn't just a technical point. A lot of people worry that they will outlive their money. A well-stocked Roth IRA, though, is one of the best protections against this possibility. Here's why
RMD requires that you begin taking distributions from your retirement plan no later than age 70 1/2. If you don’t, you’ll be subject to heavy IRS penalties. But, as mentioned, Roth IRAs do not require RMDs. You can use them to save and invest money quite literally for the rest of your life.
If you can do that, you'll never outlive your money. Even if you live into your 90s, and deplete your other retirement accounts, you will still have your Roth IRA. (That is, if you have treated it like a retirement plan, and not withdrawn the money early for unrelated purposes.)
When it comes to tax-deferred investments it's best to let sleeping dogs lie
Retirement accounts, including Roth IRAs, work best as patient capital. That means that you invest in the plans for the very long term. In this case, of course, we are talking about retirement. That should be obvious. But what has to be re-emphasized is the tax-deferred feature.
What that means for Roth IRAs, and all tax-sheltered retirement plans, is that the growth will be even greater as a result of the fact that there are no short-term tax consequences. This is perhaps the primary advantage of all retirement accounts and one that should never be taken lightly. Your goal should always be to get the full benefit of tax-deferral anywhere that you can, including with Roth IRAs.
Learn More: How to Save Money on Taxes By Retiring Early
If you withdraw money for short-term purposes, you will disturb that tax deferral process. In turn, you’ll be limiting the future value of the plan. In addition, while contributions and conversion balances may be withdrawn tax-free, withdrawals of investment earnings are fully taxable. And if you are under age 59½, you will also be subject to the 10% early withdrawal penalty.
More savings now means more tax-free income later
There’s yet another very significant benefit that is unique to the Roth IRA that makes a very strong case for simply allowing the plan to grow. Distributions from a Roth IRA are completely tax-free in retirement. The only requirements are that you are at least age 59½ and that the plan has been in existence for at least five years at the time the distributions begin.
This is an important point. If you will retire with Social Security benefits, distributions from tax-deferred plans like 401(k) plans and traditional IRAs - and maybe employer pension plans, your income in retirement may be much higher than you can imagine.
If that is your situation, distributions from a Roth IRA will be a welcome relief. You can take those distributions without worrying that they will produce a higher tax liability. In fact, a Roth IRA is a perfect tax diversification strategy. It means that at least some of the income you receive in retirement will be tax-free.
That is too big of a benefit to sacrifice in favor of short-term cash needs.
A Roth IRA can be a source of early retirement income
This is still another benefit that is unique to the Roth IRA. One of the biggest dilemmas with early retirement is having a retirement income in the early years. You know, the time before you reach age 59½ and can begin taking retirement distributions penalty-free. For example, if you retire at 50, what will you live on for 9 1/2 years before you turn 59½?
One way to do this is to live on non-retirement assets. Of course, you can withdraw these tax-free since they were never tax-sheltered. However, since most people accumulate the majority of their savings in retirement plans, this can be problematic. However, since you can withdraw your contributions and conversion balances from a Roth IRA free from taxes or penalties, the plan is an excellent source of early retirement income.
You can even set up what is known as a Roth IRA conversion ladder. That’s where you can convert funds from other retirement plans to a Roth IRA, at least five years in advance of each yearly withdrawal. That will enable you to withdraw tax-free and penalty-free income from the Roth IRA during your early retirement years when you will not qualify to take distributions from other types of plans.
Once again, if you are withdrawing money from your Roth IRA for short-term needs early in life, the money won't be there to provide you with an income in early retirement.
There are better sources of short-term cash
It’s easy to understand why someone would withdraw money from their Roth IRA accounts, for purposes that have nothing to do with retirement. Quite simply, it is usually a lack of regular (or adequate) savings. No matter what your investment situation is, you should always have ready cash available for short-term needs.
At a minimum, you should have a dedicated emergency fund for unexpected expenses or income disruption. But pure cash savings also provides a bigger picture benefit: it keeps you from liquidating long-term investments for short-term needs. You should think of liquid savings as being part of an overall investment strategy that allows your investment accounts to grow the way they should.
Apart from an emergency fund, you should also have savings plans set up for intermediate needs. These include saving for the down payment on a house or funding your children’s college educations. In fact, there are even 529 college savings plans dedicated to that purpose.
In the meantime, think of your Roth IRA plan as a long-term retirement account. That is its first, best purpose, and one that it’s uniquely qualified to provide for you, based on the very special features that it offers.